Cost Segregation: A Powerful Tool to save on Taxes
Cost segregation is a strategic tax planning tool that allows property owners to accelerate depreciation deductions, thereby reducing taxable income and increasing cash flow. This technique involves identifying and reclassifying personal property assets and land improvements that are typically embedded in a building’s construction or acquisition costs. By segregating these costs, property owners can take advantage of shorter depreciation periods under the Modified Accelerated Cost Recovery System (MACRS), leading to significant tax savings.
Understanding Cost Segregation
Cost segregation studies dissect the costs associated with a building into various components, each with its own depreciation schedule. The primary goal is to identify assets that can be depreciated over shorter periods, such as 5, 7, or 15 years, instead of the standard 27.5 years for residential rental property or 39 years for nonresidential real property.
Key Components of a Cost Segregation Study
- Tangible Personal Property: This includes items such as carpeting, wall coverings, and certain electrical and plumbing systems that are not integral to the building's operation. These assets can often be depreciated over 5 or 7 years.
- Land Improvements: These are improvements made to the land surrounding the building, such as parking lots, sidewalks, and landscaping. These assets typically have a 15-year depreciation period.
- Building Components: The remaining costs are allocated to the building structure itself, which continues to be depreciated over 27.5 or 39 years.
Legal Framework and IRS Guidance
The Internal Revenue Code (IRC) and Treasury Regulations provide the legal basis for cost segregation. Specifically, IRC Section 168 and the associated Treasury Regulations outline the rules for MACRS depreciation. The IRS has also issued various rulings and memoranda that support the use of cost segregation studies.
Key Legal Precedents
- Hospital Corp. of America v. Commissioner: The Tax Court held that property qualifying as tangible personal property for investment tax credit purposes also qualifies for accelerated depreciation under MACRS.
- IRS Chief Counsel Advice Memorandum (CCA 200648026): This memorandum clarified that property classified as depreciable personal property under Section 168 can be either real property or tangible personal property for purposes of interest capitalization under Section 263A(f).
- Accelerated Depreciation: By reclassifying assets into shorter depreciation periods, property owners can significantly increase their depreciation deductions in the early years of ownership.
- Increased Cash Flow: Higher depreciation deductions reduce taxable income, resulting in lower tax liabilities and increased cash flow.
- Tax Deferral: Accelerated depreciation effectively defers tax payments, allowing property owners to reinvest the tax savings into their business or other investments.
Conducting a Cost Segregation Study
A cost segregation study should be conducted by qualified professionals, such as engineers, accountants, and tax advisors, who have expertise in construction and tax law. The study involves a detailed analysis of construction documents, invoices, and other relevant records to identify and classify assets.
Steps in a Cost Segregation Study
- Initial Consultation: Assess the potential benefits and feasibility of a cost segregation study for the property.
- Document Review: Collect and review construction documents, blueprints, and financial records.
- Site Visit: Conduct a physical inspection of the property to identify and document the various components.
- Cost Allocation: Allocate costs to the appropriate asset categories based on their use and characteristics.
- Report Preparation: Prepare a comprehensive report detailing the findings and providing the basis for the reclassification of assets.
Considerations and Risks
While cost segregation offers substantial tax benefits, it is essential to consider the following:
- IRS Scrutiny: Cost segregation studies can attract IRS scrutiny, so it is crucial to ensure that the study is thorough, well-documented, and compliant with IRS guidelines.
- Recapture of Depreciation: If the property is sold, the accelerated depreciation taken on personal property may be subject to recapture, resulting in higher taxable gains.
- Cost of the Study: Conducting a cost segregation study involves professional fees, which should be weighed against the potential tax savings.
Conclusion
Cost segregation is a powerful tax-saving tool that can provide significant financial benefits to property owners. By accelerating depreciation deductions, property owners can reduce their tax liabilities, increase cash flow, and reinvest the savings into their business. However, it is essential to conduct a cost segregation study with the help of qualified professionals to ensure compliance with IRS regulations and maximize the benefits.
Author of this article Jack Chaudhary specializes in Individual, Corporate Tax returns, Foreign Taxes, Expats, Non-resident Taxes, Payroll, Crypto and e-Commerce. With the Enrolled Agent credential, Jack represents taxpayers before the IRS and state taxing authorities. He zealously advocates for his clients to ensure the best results are achieved. Book an appointment here with him for a consultation call.
